ESG: An Overview of Impact Investing

ESG, also commonly known as “impact” investing, involves any information related to environmental, social, and governance factors that pertain to a real-world outcome. 

ESG is commonly thought of as something that revolves around ideological inclinations, preferences, or factors that don’t explicitly tie to return. 

But It’s not just about preferences – e.g., “I don’t want to invest in carbon-intensive companies” – but about assessing a broader range of criteria that drive trading and investment outcomes. 

Capital allocators have impacts on the world that are not often explicitly quantified or acknowledged.

ESG takes more of a stance that instead of thinking of investments as a two-dimensional trade-off – i.e., between risk and return – there is an extra dimension of “impact” from environmental, social, and governance factors. 

 

esg impact investing

 

Risk is a very broad topic in trading and investing. One dimension of risk is volatility – how much does an asset move around in value?

Another is tail risk. What are underappreciated risks that can cause big losses to a portfolio?

Covariance relates to how different assets move together to provide diversification.

For example, if you own AMD (a chip company) and buy Nvidia (another chip company), are you adding more of the same risk rather than truly diversifying?

Impact is another way of thinking about real-world implications of the entire portfolio. 

For example, if you’re investing in the stock of a company, you are essentially putting up a lump sum in exchange for a stream of income over time. That income comes from what the company is doing. They are selling products and services in some form. 

What are those products and services? What is the behavior that goes into making those goods and services? And what is the real-world outcome?

Are some providing clean water, education, reducing poverty, and adding other benefits that may accrue outside the traditional analysis? 

If you’re buying commodities, what’s the process for getting them out of the ground or harvesting them and is that sustainable? And when utilizing the commodity, what are the effects of that in the world? 

If you’re buying a sovereign bond, what are the actions, outcomes, or commitments that that sovereign country is doing to impact the world around it? The money that it raises in the capital markets is influential in how it goes about this. 

ESG involves taking a more multi-dimensional approach about what kind of impact assets in the portfolio are doing more broadly and what kinds of data you need in order to assess this. 

Can an assessment be made in terms of what assets are having a positive influence on the world, which are most neutral, and which are having a more negative impact?

Everybody is accustomed to explaining why they hold something from a risk and return perspective, but the second- and third-order effects of the process might be thought of in a more limited way. 

 

Examples of ESG perspectives

An ESG perspective will look more at sustainable development goals (SDGs) as it pertains to different assets. 

Stocks

For example, a utilities company might be thought of as something with a fairly predictable year-to-year cash flow and a certain amount of volatility, but what is it really doing beyond that?

Let’s say a utilities company contributes to providing clean water and sanitation services and it does so in a way that’s less carbon-intensive than the average utility and that carbon intensity is falling over time. 

Someone looking through an ESG perspective – or at least to some degree more cognizant of ESG factors – might tilt its portfolio more toward an asset like that relative to its normal weighting in a standard index. 

It might underweight companies that are deemed to have less environmental and social impact and/or goes about its business in a less exemplary way.

Bonds

In the case of the bond market, governments are the big players, providing most of the depth to the market. 

So, you might look at all the governments in the world that tap the bond markets for capital raising and look at their behavior. 

For instance, an investor with an interest in environmental effects might try to understand governments that are subsidizing fossil fuels use versus those that are making progress in cutting back. 

Commodities

Commodities can be viewed through the lens of looking at the sustainability of their consumption and production.

Pick any commodity – e.g., oil, lithium, silver – when it’s being mined, how sustainable are those processes? And what are they being used for?

Some might shift away from oil and oil companies because of their carbon intensity. 

Some might view lithium as more beneficial because of its use in developing batteries for more sustainable transport. Then you can get into topics like the battery supply chain and its sustainability. 

Silver might be considered more neutral. Some silver is used for industrial use, while some is used in a more gold-like manner (as a type of reserve asset that people hold as an alternative currency). 

But it’s up to each market participant to determine what questions they want to ask about the asset and develop data to answer those in the best possible way. 

If the world is serious about transitioning away from carbon-intensive commodities, then a lot of different industrial commodities will be necessary to build modes of transport and charging and electricity infrastructure to get along well without energy sources that do emit a lot of carbon. 

 

Sustainable development goals (SDGs)

For most ESG investors, their number one concern is climate and how their portfolio is impacting that. 

So, a trader might look at the emissions of a company or the products they’re providing. 

Moreover, let’s say in the future companies start being penalized financially for carbon emissions. What would their earnings be if such policies were enacted to various levels of severity?

In the realm of bonds, are governments pursuing SDGs that help cut emissions or are helping bring along research and development that helps them in the world in terms of sustainability initiatives?

On commodities, they can look toward the commodities that can be produced and consumed sustainably and the ones required to get the economy away from carbon-intensive processes.

A lot of the ESG/impact framework fits more of a climate change angle, but it could be applied to virtually any issue that one wants to tackle.

It could be for things like clean water and sanitation, labor rights, education, biodiversity conservation, or any other issue. What are the causes you care about and what are the first- and multi-order consequences that these portfolio investments are having?

This can lead to new insights and new approaches that can better help inform a standard risk and return framework as well.

 

Measuring sustainability risk is in the early stages

Just as many years ago we were in the early stages of measuring risk to reward in traditional portfolios, we’re now in the early stages of measuring sustainability risk as a type of alternative dimension to risk. 

There are many different perspectives and different types of data that people have an interest in to help explain what impact they’re having making these choices.

 

ESG Data

Reliable and consistent data is the biggest roadblock for capital allocators looking to adopt an ESG framework into their investing process. 

Data is based on what kinds of questions market participants are trying to answer and what kind of assessments they need to make. 

In terms of traditional risk, people want to understand their standard risk of capital loss. As a result, they came up with various ways to measure volatility over time – e.g., volatility expressed as a daily, monthly, quarterly yearly, or some customized time horizon.

And they also want to understand the distribution of this risk. Equities, for example, have large left-tail risks. For this, people came up with measures such as Value-at-Risk (VaR) and expected shortfall. 

They also want to know how different assets work together, so they study things like covariance. 

ESG data might try to answer questions that relate to the economic costs of production and consumption of a commodity. 

What would be the knock-on effects in other parts of a portfolio? 

If one commodity becomes less favored and another becomes more favored due to regulations, secular shifts, and/or other causes, how does this impact the revenues, cost structures, and/or the overall profitability picture for certain types of companies and their credit and equity? 

How would it impact the finances of certain governments?

For example, it’s widely known that the oil market has a material effect on the finances of Saudi Arabia, Norway, Qatar, among other countries. 

As the questions become more well-defined, the data will become better as more providers spring up in the industry and become more effective at providing investors with the kind of data and information they need.

Whatever data is used will also need to be compared alongside other providers.

 

Having questions, deriving answers, and making decisions in light of them

Capital allocators will also need to get at how the questions they ask and their answers to them are most relevant to their portfolios. 

For instance, when it comes to the amount of projected warming based on certain amounts of carbon in the atmosphere, that’s a question that’s probably most directly applicable to commodities. 

So, an investor will need to understand how certain commodities interact with the world. What initiatives or regulations might come out of certain governments or even at the international level in some form?

What would it mean for oil and how much would that impact the demand for other commodities like copper, natural gas, and so on (i.e., those commodities that may benefit) versus those that would be negatively impacted?

And it also impacts other questions like how much oil would need to be left in the ground versus the amount pumped out.

Also, investors care a lot about sustainable development goals outside of solely environmental considerations. This includes things like biodiversity, clean water, sanitation, poverty, and other issues. 

From the perspective of poverty, oil might not score as badly as it does when it comes to someone concerned about environmental or climate risks. 

Oil can provide electricity, transportation, industrial activity, new products, and other positive forms of economic activity that can improve living standards in heavily impoverished areas. This is especially true in the absence of economically viable sources of energy.

So, there are multiple perspectives to assess a range of potential outcomes as it pertains to the “impact” part of the spectrum to go along with traditional risk and reward. 

And naturally, many of the issues are interconnected. Poverty and access to clean water and sanitation are one example.

Not letting bias get in the way of objectivity

ESG is an area where it’s quite easy for people to let their personal opinions or qualitative judgments interfere with their objectivity, which is harmful to quality decision-making.  

Some topics are inherently political in nature, such as drilling for oil. However, in trading and investing, in particular, it’s not about what you want to be true, but about understanding what is true to the best of your ability and how to make decisions in light of that. 

This is also true on the impact side of the equation (i.e., the effect). For example, does divesting from fossil fuels companies – i.e., not investing in oil and gas companies – help have a positive environmental and social impact? For allocators who are into the idea of a carbon-neutral portfolio, they might even short heavy carbon emitters.

And also, what does “positive impact” mean in terms of something that’s quantifiable? You could define this as a reduction in carbon emissions, for instance. 

And whether such practices have helped or are helping reduce carbon emissions is not entirely clear. Based on some data, one might conclude that not investing in oil and gas companies doesn’t do much to prevent carbon emissions from rising each year. 

Rather, evidence might suggest that investing in emerging energy technologies is more effective than trying to reduce the amount of capital flowing to companies that grade out poorly on some construction of ESG measures.

What if data is conflicting?

If data between two providers conflicts on, for example, the carbon-intensity of a company, you can either confer with one or more other providers or make a decision based on existing data. 

Or one could pass on any investment, from an ESG inclusion perspective, that doesn’t meet the bar based on the data you currently have available. 

For example, if you’re looking at equities from an ESG framework, you have a choice among thousands of companies. 

However, the marginal benefit of investing in additional equities past a certain number is very low. That means the marginal costs of having high standards are low. 

For example, if one assumes that stocks are each 75 percent correlated, investing in 25 doesn’t diversify away much overall market risk relative to investing in 10. 

 

 

The same can be said of investing in 25 stocks versus 10 stocks if you assume the correlation among them is as low as 50 percent. 

 

 

For the long-term investor’s portfolio, this is not a recommendation to hold only 10 to 25 companies. There is still idiosyncratic risk, even if market risk is not a huge factor past a certain point. 

If just one stock were to lose half of its value, that 2-5 percent of the portfolio’s value gone. If you hold 100, it’s a more manageable half of one percent. 

Rather, it’s the general idea that you don’t need to go overboard with diversification if it’s not accomplishing anything extra. 

Let’s say that someone wanted to apply an ESG framework to the S&P 500 and cared a lot about the diversification element. 

It’s still very possible to hold a relatively high bar on the impact requirements for a company to pass into the index without having to worry about losing the diversification element. 

Even if 80 to 90 percent of the companies in the S&P 500 ended up being disqualified by your impact metrics, leaving you with 50 to 100 companies, the actual amount of diversification lost is quite minimal because of the correlation in exposures across equities is so high regardless. 

At 50-75 percent correlation, the total amount of diversification lost going from 50-100 companies to 500 companies is less than one percent. The risk/reward profile is still relatively high and very comparable going from a more minimal approach (e.g., 50 companies) to something more thorough. 

The general idea is that you’re basically paying very little from a diversification perspective by integrating the impact perspective into the asset allocation.

In some way, this can quell fears that many investors have about ESG that adopting impact processes can adversely affect their returns.  

 

Sectoral implications

In equities, there are some implications by sector. 

But a lot of funds that pursue impact investing try to keep the sector weights the same such that they still give a representation of the overall market.

Some ESG funds might exclude oil and tobacco companies, for example. But at the same time many of them are set by various preset rules to keep them as close to the market as possible.

The benefit to this is in preventing too much of a tilt such that it could over- or underperform for reasons that don’t relate to impact investing goals. 

Oil and tobacco companies are more mature, “value” sectors. Eliminating them could result in an overrepresentation of newer, growth-focused companies. That could present its own risks in the form of higher exposure to duration (more earnings discounted in the future than the present) as well as less overall diversification. 

Others may have more of a sector tilt rather than trying to keep the sectoral weights as equal as possible. 

Some funds might look at a broader selection of sustainable development goals to avoid allocations that shift the sector weightings too heavily.

Even within sectors that tend to fall short of standard ESG goals (most notably oil and gas), many companies within the sector are developing alternative energies such as wind and solar as well as technologies that can help offset carbon emissions, such as carbon capture.

Outside the scope of ESG, sector and country weights are always shifting around even though that’s rarely talked about.

If tech goes up more relative to others, then tech will become a greater part of your portfolio and other sectors will become of a weight. 

And oftentimes assets go up in a way that reduces their forward returns rather than actually being a better investment. 

Accordingly, those shifts can bias a portfolio more relative to something like pursuing impact investing. 

 

Diversification in other asset classes

In commodities, even if a capital allocator is not thinking about ESG, diversification is important. 

Most tend to be very concentrated in oil especially and tend to under-own other commodities relative to what one would want to be in order to be balanced

From more of an ESG perspective, oil has not only the high idiosyncratic risk but risk in the form of what happens if more of the world transitions away from carbon. 

There are lots of other commodities available that could make sense not just in terms of normal risk diversification in a portfolio – e.g., exposure to an inflationary environment – but in terms of what could drive their demand for impact and non-impact-related reasons. 

If carbon is being phased out in some growing capacity, then there are lots of other types of commodities that are going to be in demand to help capture some of this trend, such as lithium, cobalt, copper, natural gas, aluminum, and so on. 

So, for commodities, there’s not only the idiosyncratic risk associated with being concentrated in oil but also the impact risk as well as a result of where the world could be going. 

Where diversification is commonly missing

Most investors are not well diversified toward certain environments.

Equities do well in a certain environment – i.e., when growth is above expectation and inflation and inflation expectations are low to moderate. 

But other asset classes are important as well when it comes to having a balanced portfolio and also have a favorable impact on the world. 

Things like certain types of commodities, as mentioned, to go along with nominal and inflation-linked bonds and diversification by countries and currencies

 

The new paradigm and its influence on ESG investing

In developed markets, short-term interest rates are at zero. Long-term interest rates are also very close to zero through the quantitative easing programs of central banks.

That’s put all of the main reserve currency areas of the world – the US, EU, and Japan – in a type of scenario where getting stimulus into the economy now revolves around a unification of fiscal and monetary policy

When monetary policy ceases to be effective in the traditional ways because nominal interest rates can only go down so low (around zero or a little bit below), the economics of borrowing and lending can no longer be changed in the normal ways.

That means the management of the economy largely goes from being mostly within the purview of the central bank to shifting more toward fiscal policymakers – i.e., the politicians.

And with fiscal policy taking more of a role, that brings with it a type of unique decision-making. Politicians can dictate where they want money to go to and who they’d like to bypass. 

Interest rate-driven monetary policy – as in the case of interest rate hikes/cuts and QE – is more broad-based and much less targeted relative to fiscal policymakers picking where they want resources to go, with the central bank funding those initiatives. 

Some will be beneficiaries of an economy that’s more heavily run by the fiscal side and some will not be. 

There are many calls in the developed world for an increasing shift away from a carbon-intensive economy. So they can have an impact on these issues.

This means direct government action can be more influential on one’s portfolio based on where the support and monetization is going and benefiting. 

 

What’s holding people back from adopting ESG into their capital allocation processes?

Many are not sold on the idea of ESG.

Far and away the top concern is the lack of data that’s available. Others are concerned that ESG focuses too much on things that are not directly related to investment returns and/or improvements in risk management processes.

It may be difficult for some investors to make an effective argument for an ESG framework with clients and other stakeholders.

Can capital allocators make a convincing argument for ESG on its own merit based on evidence that it can improve a portfolio’s overall return and risk profile?

For large institutions, they may have reservations over whether they can make sustainable investments at scale. Those involved in the non-profit space will understand that there is a limited set of opportunities that have both an economic return and a social and philanthropic return.

Infrastructure projects are commonly left largely to the public sector as they have long lead times and some benefits are harder to quantify (e.g., industrial efficiency). Some services in the education and healthcare space are often left to the government as well.

 

Conclusion

ESG is becoming a bigger part of the investment landscape. Many capital allocators have sustainable development goals they’d like to pursue in their portfolios. 

Many are thinking more and more about how the assets they hold in their portfolio interact with the world and how certain assets drive real-world outcomes. 

By and large, standard risk and reward measurements are the chief concerns of traders and investors.

But ESG frameworks are becoming more popular as another subset of data and information that can help make effective investment decisions. 

Inhibitions surrounding ESG and impact integration within the investment process, especially in public market assets, include:

  • Lack of availability of reliable and consistent data
  • Worries over giving up too much return
  • Availability of sustainable investments at scale
  • Communication with members and stakeholders
  • Challenges concerning ESG and impact acceptance
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